Gold, Energy, and Unintended Consequences in the Headlights

Serendipity - the occurrence and development of events by chance in a happy or beneficial way.


Ok it's already late, and I want to cover a range of items in this article.  So let's jump right in...

Even More on Gold

A few hours after I posted Gold, Another Diversification Option, I received John Mauldin's free weekly Outside the Box newsletter to which I am a subscriber.  This week's letter provided some background on why investors like Warren Buffet think of gold as a bad investment choice.  Simply stated, Benjamin Graham, Warren's mentor, never invested in it.

According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham's theory clearly shows periods when one asset class offered a better value than the other:

But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives. 

It's clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham's allocation model. 

But this missing asset class is entirely understandable: for most of Graham's adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn't re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds. 

All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold? 

We can never know.

This confirms what I said in Gold, Another Diversification Option:

Just like all investment classes go in and out of favor, I believe the same is true for gold. 

As I mentioned, I am a John Mauldin subscriber.  John puts out two well thought out newsletters weekly - Thoughts from the Frontline and Outside the Box.  These letters are free and you can sign up at www.johnmauldin.com.

Wrapping Up the Gold Discussion

After writing Gold, Another Diversification Option, I received the following request.

Could you describe how you go about selecting which gold fund to invest in? What tools / logic do you use?

Whenever I buy into a mutual fund or an ETF, I follow the basic premise behind lazy investing as told in Maybe I'm Not a Lazy Investor.

Thus if you build a diversified portfolio of low-cost stock and bond index mutual funds, you stand a very good chance of earning a higher return than you would otherwise. Why is it called lazy investing? Primarily because the only action required is an annual rebalancing of your portfolio to ensure that it stays diversified. Total time required to rebalance is less than 15 minutes for the entire year. (Read the How To Build a Lazy Portfolio here) 

This information all made perfect sense to me. The only hiccup to implementing this in my 401k plan was the lack of low cost index mutual funds. So I did my best by picking the lowest cost funds that gave me exposure to the large company US stocks, small company US stocks, international stocks, and bonds.

There is not an index fund for gold or gold mining companies, so I look for funds that have a low expense ratio and good performance over the last 10 years. Low cost (expense ratio) is important because it's the only choice that I have control over. Yes investing is a choice too, but when you're in a mutual fund or ETF, it's the investment manager that chooses the individual investments. Cost is all I can control.

Additionally I want good performance over the past 10 years because gold's in a big bull market. If a manager cannot make money in a bull market, then it's time to find a new manager.  Note you will also want to screen for no load funds.  Loads are a fee mutual fund companies collect to pay financial advisors for recommending their product.  Stay away from load funds as that's lost money from the beginning.

Finally, you can use any screener to find this information.  For mutual funds, I had the best luck using Morningstar.com with the following settings:

• Fund group: Commodities
• Morningstar Category: Equity Precious Metals
• Load Funds: No Load Funds Only
• 3, 4, & 5 star funds
• 10-year return greater than or equal to: Category average

There were 11 funds listed, most with an expense ratio around 1%.  

For ETFs, I used google and found the ETFdb: The Comprehensive & Original ETF Database.  This wasn't around years ago, but made finding the ETFs available easy.  I'll make it easier on you by linking directly to:

• Gold ETFs
• Gold Miner ETFs

By the way, I've invested in both gold and gold miners for diversification.  They tend to move together, but just in case one soars, I want to take advantage of it.  Also please remember that you need to investigate all ETFs and mutual funds thoroughly before investing.  Otherwise please talk to you financial advisor. 

Moving on to Other Thoughts

This past weekend I played golf with one of my best friends, Rudy.  It had been awhile since we had last seen each other, so we caught up on each other's lives and eventually I brought up this blog.  The conversation immediately turned to investing, and to a topic where my buddy is intimately familiar - energy.

Rudy's knowledge of energy comes from working for a large construction firm that among other things builds and maintains power plants and storage facilities. He mentioned that while things have been steady, energy expansion is ramping up quickly to keep up with demand.  I wish I had kept notes, but needless to say, my friend is bullish on energy.

My conversation with Rudy focused my mind.  I have always liked energy as an investment because everyone uses it every day.  I admit that I have been cautious about the sector (probably too cautious) because when recession hits again, energy demand will fall, which will lead to lower prices.  On the other hand, energy will always come back because as I said, everyone uses it every day.

While driving home from the golf course, a number of recent issues came to mind:

• Tensions with Iran could lead to higher oil prices.
• Japan has shutdown all nuclear power plants, so it'll need to find another energy source somewhere.
• Germany pledged to shutdown all nuclear power plants by 2020, so it too will need another energy source. 
• Central bank liquidity needing to find a place to call home.

I think this bodes well for energy producing companies, countries, and those companies that support them.

Unintended Consequences

Unintended consequences seem to happen any time there is a mix of politics and economy.  As Bloomberg reports in Euro-Area Central Banks Said to Swap Greek Portfolio Bonds.

Euro-area central banks will swap the Greek bonds in their investment portfolios for similar securities to avoid enforced losses during a debt restructuring, a euro-area official said.

The swap will happen today and is identical to one the European Central Bank carried out last week with the Greek bonds acquired in its asset-purchase program, the official said. The new Greek bonds will be immune to collective action clauses, or CACs, ensuring central banks don’t incur any losses when a private-sector debt write-down takes place, the official said on condition of anonymity. A spokesman for the Frankfurt-based ECB declined to comment.

Central banks decided that they didn't like their bond contracts that they voluntarily entered into when they purchased said bonds.  So they decided to change the contract by swapping old bonds for new bonds that wouldn't be subject to any losses.  What could go wrong here?  

Essentially central banks have told all other bond investors that their holdings are now junior to central bank holdings.  A dangerous precedent has now been set for other countries where central banks have bond holdings, namely Italy and Spain.  While the EU wants investors to buy sovereign bonds from Italy and Spain to keep rates low, what investor in his right mind would now did so since central banks have proven that they can change the rules of the game in the 2nd half?

The ECB better hope that the Long Term Refinance Operation (LTRO) money is used to buy sovereign debt because they will one day find out that no one else is going to buy it.

Looking Ahead in the EU and U.S.

Ironically what made me start this section was looking back at what I've written so far. The first big date to look ahead to is February 29th in the EU.  The second installment of the LTRO is due, and I've heard that it may loan out LESS money than the first issue this past December.  

We'll have to wait and see what happens, but remember as I stated in It's Only Good for a Limited Time:

... by unleashing a flood of liquidity in the form of low interest rates, quantitative easing, and refinancing operations, world central banks distort financial markets encouraging investors to take on more risk. Stocks are a natural fit, especially with reports and prognostications of an improving economy.

If there is less money loaned out, that means less liquidity added.  Stock may well fall as they have stalled at the current level several days.  

The payroll tax cut has passed Congress, but don't count on a large boost to spending as reported in the Big Picture Blog Greece/China/gasoline prices. 

In the US, gasoline prices according to AAA rose for the 26th straight day yesterday, up by .03 over the weekend to $3.57 per gallon. Over this time frame, prices are up about .20 which equates to about $28b annualized out of consumer pockets, almost 1/3 of the payroll tax cut.

Finally QE3 is still waiting should stocks drop to much.  Again from the Big Picture: Here Comes Dow 13,000. Then What?

The post credit crisis sequence seems to operate thusly: Markets slide lower on weak fundamentals. They accelerate down on stop losses and risk management. They plummet on panic. The intervention of some sort occurs. The experienced market/Fed watchers know the impact, and jump in. As markets move off lows, some value types, cycle historians, and then technicians jump on board. The rally may be distrusted or even hated, but eventually trend followers then momentum boys join the party. Pretty soon, its all aboard the Love Train, and not too long after, markets reach their over bought condition. The cycle begins anew.

I wonder what the plan is when the payroll tax cuts and income tax rates expire come January 2013? Or is that going to be the next administration's problem?

Parting Thoughts

For the first time since 2007, I'm thinking that I need to add stock exposure in my retiree portfolio.  In particular, I will be investigating, with the intention of buying, mutual funds that invest in energy companies.  As I'm not sure what the market will do, I plan on scaling my purchases.  This means I'll divide up my total investment and make my purchases over many months.  In other words, this method is really dollar cost averaging in disguise when investing a preset amount. 

Did I mention that you need to read the disclaimer below?

Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.